Panic sooner rather than later

THE TWO largest investors in the UK stock market are pension funds and life insurance companies. Both have good reasons to sell. There has been a growing realisation of the risks they run when investing in the stock market. Share prices fluctuate for all investors but pension funds and insurance companies have an additional problem - they have liabilities to meet.

The value of these institutions rises and falls with the difference between the value of their assets and their liabilities. If these two values fluctuated together, there would be no problem.

For this to happen, institutions would have to match their assets with their liabilities. A promise to pay £1m in 10 years could be matched exactly by a Government bond that would be repaid then. But their assets don't match their liabilities. The bear market has been teaching investment managers just how quickly falls in the stock market can destroy the value of the businesses they run.

In the case of life insurers, the impact of asset prices falling faster than liabilities is shown up in the industry's free asset ratio. According to Nottingham University's Centre for Risk and Insurance, this ratio deteriorated over the two years to end-2001 from 19.1% to 7.12%. It has no doubt fallen further this year with the weak stock market.

Two other changes have added to the trouble caused by the stock market. Retired people are living longer and bond yields have fallen. Both of these changes have increased the cost of pensions and annuities. Not only has the value of assets been falling, but the value of the institutions' liabilities has been rising.

The seriousness of the problem was highlighted by Paul Armstrong, when he reported in the Evening Standard (26 June: Life insurers face Footsie fall burden) that life insurers could be forced to sell if the FTSE 100 index falls below 4200.

The Financial Services Authority wants to avoid a vicious circle in which falling share prices force sales, which will cause further falls and further sales. It has therefore eased the 'resilience test' designed to test insurers' solvency. Under the new arrangements, the test remains in place but is less subject to short-term falls in the market. But the risk remains if the market stays low for three months or more. Even if the stock market bounces back, the longer-term outlook for shares is discouraging.

Both pension and life funds are likely to hold a lower proportion of shares in their portfolios in the future. This is partly because the risks of mismatching assets and liabilities have been so strongly emphasised by the bear market. It is also because the risks of a bear market creating a vicious circle have been so forcefully underlined.

Poor stock markets mean poor bonuses. Poor bonuses mean fewer with-profits policies. This will reduce the insurers' appetite for shares and encourage further falls in their prices. Investors are often advised not to panic. The key, however, is to panic early rather than late.

www.smithers.co.uk